Saturday, June 5, 2010

The Hidden Terror of Inflation

The million dollar question: Should we be worried about inflation?

I'm mostly concerned with this question because it is one we haven't asked in a while. The last time inflation was an issue was in the mid-to-late seventies, which, coincidentally, is around the time I was born. So basically anyone like me under (cough cough) thirty years old has never lived in an America that ever had to even think about inflation.

However, some economists and business journalists are starting to worry. Not for anything particular in today's economy, but the tempting taste of inflation may be beyond the government's ability to ignore. (See here and here for examples.) And I'm starting to worry, too, because I'm not so sure there are enough people out there who understand exactly how crazy such a plan would be.

[Inflation--for those who weren't paying attention in Econ 101--is a general increase in the price of goods and services. Basically, it makes each dollar worth less as time goes by--$1.00 today may be worth 98 cents next year. And as a general rule, during times of economic booms, inflation becomes higher, and during recessions it becomes lower. The Federal Reserve's job is to monitor all of these factors and try to keep the inflation rate at a specific target by altering the money supply.]

Inflation is a tricky subject, because few people understand it--economists have a checklist of about 20 different reasons that inflation occurs. I'm an Austrian at heart--my dog's middle name is Hayek, for crying out loud--so I have one reason: changes in the money supply. (Actually, I'm not that theoretical. I'll gladly concede that, in today's global economy, forces that are beyond rational expectations will eventually filter their way back to the American marketplace. But for the purposes of what is going on now, I'll stick with this.)

Anyway, inflation isn't necessarily a bad thing--so long as it's fairly low and fairly stable. Those that are supporting an inflationary policy are forgetting the nightmarish years of the 70's that nearly destroyed the economy, when inflation routinely topped 10%. (The inflation rate for the past thirty years has largely hovered around 2-3%.)

[Historical diversion, and skip if you already have a headache: There were several reasons for the inflation of the 1970's, but it can be boiled down to three reasons. First are the multiple OPEC embargoes. Oil, unlike most goods, affects nearly every inch of the economy, especially back then, so the price hikes and rationings causes prices to rise for nearly everything. Second was Nixon abandoning the gold standard (this impact was most likely minimal). But the main reason was Lyndon Johnson--he didn't want to fund the Vietnam war by raising taxes, so he just printed up the extra money. It took a few years before it filtered into the system and by that time Nixon had to deal with it. Nixon, Ford, and Carter all struggled with inflation with little luck; the only sure way to sure it would be to lock down interest rates. This, alas, would cause a deep, deep recession. Which is exactly what Federal Reserve chairman Paul Volker (under Ronald Reagan) did, and this is why the 1982 recession occurred and was so deep and terrifying. However, it was something that had to be done to effectively "reset" America's economy. Recessions aren't good, but spending the next few decades with 10% inflation would have been infinitely worse.]

It's not necessarily a good idea to have no inflation. In the real world, inflation acts as a sort of lubricant to prices and wages--when fixed prices (due to contracts and other market forces) can't move, the economy grinds to a halt. Inflation, by changing the value of money, is sort of a proxy for getting prices to move. As long as it's low and we expect it to happen, the trade-offs are pretty much worth it.

But you don't want too much inflation, either. Inflation causes the value of the currency to decrease, so people who were smart and saved their money will find themselves holding the bag. People in circumstances will convert that money into less productive uses just to save their own skin, distorting exactly how much their money is worth. This is what was happening in the 70's, when mortgage interest rates were skyrocketing and business were scared to sign contracts and plan for the long-term, things you don't want to have happen in a healthy economy. In addition, inflation has a tendency to feed off of itself, especially if the future is uncertain.

Of course, the flip side is true--inflation will help people who owe money. If you owe, say, a thousand dollars, but that is only worth seven hundred dollars in ten years after inflation has eaten away the value, you're better off. This is why William Jennings Bryan won three nominations at the turn of the last century--farmers wanted the government to make their debts virtually worthless by effectively debasing the currency with abundant silver instead of solid gold. Of course, for everyone else who doesn't owe debt, their real savings and incomes get destroyed.

And this is why inflation seems to be making a comeback. Only this time, it's not the farmers that want the debt erased, it's the US government. The deficit is getting so large that one of the solutions--you know, instead of raising taxes or cutting spending--is to print more money to make that debt less of a burden.

Now, having the same entity in charge of determining the inflation rate that owes the debt seems like a crucially important conflict of interest to acknowledge, but that is what is happening right now. And I see that as one of the looming upcoming battles--the Federal Reserve versus the economic policymakers in the White House and Congress. And the American people just might be sold on it--so many people owe so much money, they may look at this solution as an easy way to 1) ease their debt burden while 2) sticking it to those rich people who save all their money in a bin in their back yard. Of course, the fact that all that stuff you buy every day will also get increase--not to mention that once your debt is paid you no longer get the benefits but still get to pay those higher prices--is exactly the sort of long-term strategic thinking that voters are notoriously horrid at evaluating.

So I'm just afraid most people will be sold on the benefits of inflation without considering the drawbacks--and as the 1982 recession taught us, the medicine to fix the ailment is not pretty. (And to be honest, this isn't a campaign issue anyone can figure out, so it may be one of those things that the government just does, and the only people who understand it are business reporters and Wall Street types. Voters don't tend to value such opinions when it comes to election day.) So far, when it comes to monetary policy, Obama seems to have a fairly long-term vision of how things should work. (Fiscally, not so much.) I'm not worried yet, but I have reason to start throwing up red flags.

The Pledge: The government wants to take your money. If they can't tax it, they'll make your money worth less than it did before and take it that way instead. You can plainly see a tax hike, but most people won't notice inflation until it's too late. But the effect is the same. Just remember who to blame when the time comes.